Emerging markets are outpacing S&P 500 despite inherent risks

Last year, emerging markets finally reversed their multiyear slide with the benchmark MSCI EM index gaining more than 11%. Through May 8 this year, the index advanced another 14.24%, outpacing the S&P 500, the Russell 2000 and the MSCI EAFE indexes.

There is no guarantee that the outperformance will continue, but advisers who believe it will may want to consider the asset class for tactical allocations.

There are currently 11 unhedged dividend-focused emerging markets ETFs. Some have methodologies that result in a narrow stock selection, while others are fairly new and have not been around for both good and bad periods in the emerging markets. Each of these ETFs is at least five years old and holds more than 50 stocks:

The iShares Emerging Markets Dividend ETF (DVYE, expense ratio: 0.49%) is a portfolio of 100 dividend-paying EM stocks based on the Dow Jones Emerging Markets Select Dividend Index. That index is formed by taking the S&P Emerging Broad Market Index and excluding REITs. To be eligible for the DJ EM Select Dividend Index, a company must have paid a dividend in each of the past three years and must have non-negative trailing 12-month per-share earnings. In addition, it must have a minimum market capitalization of $250 million. Stocks passing the screens are ranked by indicated annual yield.

The top 100 stocks are included in the index, subject to buffers: No more than 30 stocks may be from any one country and no country may represent more than 25% of the index. Financials, utilities, and technology companies currently have the greatest weight in the ETF, which made its debut in February 2012. Largest country positions are in Taiwan, China, and Russia. DVYE has a five-year Sharpe ratio of zero.

The SPDR S&P Emerging Markets Dividend ETF (EDIV, 0.49%) is based on the S&P Emerging Markets Dividend Opportunities Index. That index is derived from the S&P Emerging Broad Market Index by imposing a minimum market cap of $300 million and by requiring positive 12-month per-share earnings (excluding extraordinary items). In addition, stocks must have stable or increasing dividend growth over three years and per-share funds from operations must be greater than the dividend per share. Yield must be higher than median yield in the eligible universe of stocks meeting the other criteria.

Stocks are ranked by risk-adjusted yield (yield/volatility of yield over 36 months). The index holds 100 stocks but EDIV has 146 positions. That number includes 26 cash holdings of different currencies and multiple classes of several Thai stocks. Launched in February 2011, EDIV’s current largest sector weightings are financials, consumer discretionary, and technology. Top country weightings are South Africa, Taiwan, and China. EDIV’s five year Sharpe ratio is -0.22.

The WisdomTree Emerging Markets High Dividend Fund (DEM, 0.63%) owns more than 300 dividend-paying EM stocks. The underlying benchmark is the WisdomTree Emerging Markets High Dividend Index, which contains securities ranking in the top 30% by yield from the WisdomTree Emerging Markets Dividend Index. Both indexes are weighted by cash dividends paid. The fund, launched in July 2007, has its highest sector exposure in financials, telecommunications services, and energy. Largest country holdings are in Taiwan, China, and Russia. The five-year Sharpe ratio for this ETF is 0.08.

The WisdomTree Emerging Markets SmallCap Dividend Fund (DGS, 0.63%) holds more than 600 stocks that fall within the bottom 10% of total market capitalization of the WisdomTree Emerging Markets Dividend Index. Companies are weighted in the index by cash dividends paid. The largest sector exposure is in consumer discretionary, technology, and industrials. Biggest country weightings are Taiwan, China, and Thailand. Launched in October 2007, DGS has the best risk-adjusted performance of the four ETFs described. (Five-year Sharpe ratio: 0.21)

Keep in mind that emerging market investments entail currency risk. In addition, company dividend histories are not as long as in developed economies, so portfolio turnover can be greater.